The essential
feature of Islamic banking is that it is
interest-free. Although it is often claimed that
there is more to Islamic banking, such as
contributions towards a more equitable distribution
of income and wealth, and increased equity
participation in the economy (Chapra 1982), it
nevertheless derives its specific rationale from the
fact that there is no place for the institution of
interest in the Islamic order.

Islam
prohibits Muslims from taking or giving interest (riba)
regardless of the purpose for which such loans are
made and regardless of the rates at which interest
is charged. To be sure, there have been attempts to
distinguish between usury and interest and between
loans for consumption and for production. It has
also been argued that riba refers to usury
practised by petty moneylenders and not to interest
charged by modern banks and that no riba is
involved when interest is imposed on productive
loans, but these arguments have not won acceptance.
Apart from a few dissenting opinions, he general
consensus among Muslim scholars clearly is that
there is no difference between riba and
interest. In what follows, these two terms are used
interchangeably.

The
prohibition of riba is mentioned in four
different revelations in the Qur'an (1)
. The first revelation emphasizes that interest
deprives wealth of God's blessings. The second
revelation condemns it, placing interest in
juxtaposition with wrongful appropriation of
property belonging to others. The third revelation
enjoins Muslims to stay clear of interest for the
sake of their own welfare. The fourth revelation
establishes a clear distinction between interest and
trade, urging Muslims to take only the principal sum
and to forgo even this sum if the borrower is unable
to repay. It is further declared in the Qur'an that
those who disregard the prohibition of interest are
at war with God and His Prophet. The prohibition of
interest is also cited in no uncertain terms in the
Hadith (sayings of the Prophet). The Prophet
condemned not only those who take interest but also
those who give interest and those who record or
witness the transaction, saying that they are all
alike in guilt (2)
.

It may be
mentioned in passing that similar prohibitions are
to be found in the preQur'anic scriptures, although
the 'People of the Book', as the Qur'an refers to
them, had chosen to rationalize them. It is amazing
that Islam has successfully warded off various
subsequent rationalization attempts aimed at
legitimizing the institution of interest.

Some scholars
have put forward economic reasons to explain why
interest is banned in Islam. It has been argued, for
instance, that interest, being a pre determined cost
of production, tends to prevent full employment
(Khan 1968; Ahmad n.d.; Mannan 1970). In the same
vein, it has been contended that international
monetary crises are largely due to the institution
of interest (Khan, n.d), and that trade cycles are
in no small measure attributable to the phenomenon
of interest (Ahmad 1952; Su'ud n.d.). None of these
studies, however, has really succeeded in
establishing a causal link between interest, on the
one hand, and employment and trade cycles, on the
other. Others, anxious to vindicate the Islamic
position on interest, have argued that interest is
not very effective as a monetary policy instrument
even in capitalist economies and have questioned the
efficacy of the rate of interest as a determinant of
saving and investment (Ariff 1982).

A common
thread running through all these discussions is the
exploitative character of the institution of
interest, although some have pointed out that profit
(which is lawful in Islam) can also be exploitative.
One response to this is that one must distinguish
between profit and profiteering, and Islam has
prohibited the latter as well.

Some writings
have alluded to the 'unearned income' aspect of
interest payments as a possible explanation for the
Islamic doctrine. The objection that rent on
property is considered halal (lawful) is then
answered by rejecting the analogy between rent on
property and interest on loans, since the benefit to
the tenant is certain, while the productivity of the
borrowed capital is uncertain. Besides, property
rented out is subject to physical wear and tear,
while money lent out is not. The question of erosion
in the value of money and hence the need for
indexation is an interesting one. But the Islamic
jurists have ruled out compensation for erosion in
the value of money, or, according to Hadith, a
fungible good must be returned by its like (mithl):
'gold for gold, silver for silver, wheat for wheat,
barley for barley, dates for dates, salt for salt,
like for like, equal for equal, and hand to hand
...' (3)
.

The bottom
line is that Muslims need no 'proofs' before they
reject the institution of interest: no human
explanation for a divine injunction is necessary for
them to accept a dictum, as they recognize the
limits to human reasoning. No human mind can fathom
a divine order; therefore it is a matter of faith (iman).

The Islamic
ban on interest does not mean that capital is
costless in an Islamic system. Islam recognizes
capital as a factor of production but it does not
allow the factor to make a prior or predetermined
claim on the productive surplus in the form of
interest. This obviously poses the question as to
what will then replace the interest rate mechanism
in an Islamic framework. There have been suggestions
that profit-sharing can be a viable alternative (Kahf
1982a and 1982b). In Islam, the owner of capital can
legitimately share the profits made by the
entrepreneur. What makes profit sharing permissible
in Islam, while interest is not, is that in the case
of the former it is only the profit-sharing ratio,
not the rate of return itself that is predetermined.

It has been
argued that profit-sharing can help allocate
resources efficiently, as the profit-sharing ratio
can be influenced by market forces so that capital
will flow into those sectors which offer the highest
profit sharing ratio to the investor, other things
being equal. One dissenting view is that the
substitution of profit-sharing for interest as a
resource allocating mechanism is crude and imperfect
and that the institution of interest should
therefore be retained as a necessary evil (Naqvi
1982). However, mainstream Islamic thinking on this
subject clearly points to the need to replace
interest with something else, although there is no
clear consensus on what form the alternative to the
interest rate mechanism should take. The issue is
not resolved and the search for an alternative
continues, but it has not detracted from efforts to
experiment with Islamic banking without interest.